New Traffic Lights for Wall Street

It’s that time again. Every financial crisis eventually reveals deficiencies in the public supervision and regulation of the credit system and this downturn has been no different. Despite the fact that financial controls were initially conceived to prevent crashes, they are often a contributory reason to the breakdown. Therefore, crises often bring about demands for better control of the financial markets.

Such is the case today, particularly in the United States, the source of the current economic misery.

A simple answer to solving this situation is the view that whatever broke down on the road to the present crisis ought to be easily repairable. The fundamental fault of the American regulatory system was that no one – neither a regulatory authority nor the Federal Reserve – had a clear picture of the total amount of credit in the United States economy.

American politicians and authorities have so far ignored the principal piece of wisdom gleaned from the history of financial crises, namely that the collective volume of credit is the driving force behind all bubbles and financial crises, even today’s economic downturn.

Because of this, supervision should cover the whole of the financial market. Only then does the regulatory authority get a map that sufficiently clarifies the complex and critical links between different financial institutions and credit markets.

Such a systematic investigation is the obvious starting point for public control of the financial market. But such is historically not the case in America. There, financial inspection is split between different organs. Federal and state authorities watch over their own territories. Different credit institutions have different regulators.

Even worse, some areas, such as hedge funds and investment banks lie, beyond financial control. Other economic entities have the privilege of selecting who can oversee them. They surf between different regulatory bodies and choose the one, which, at that moment, appears the most generous and accommodating.

Furthermore, control hasn’t kept pace with the rapid progress of financial technology. Enormous markets in complex bonds, known under all types of three-lettered abbreviations such as CDO, CDS and FRA, lie outside public scrutiny. The same is true for the credit market, which the banks hide outside their balance sheets along with those in the so-called shadow banking system.

Because only parts of the financial credit system are being inspected, the American authorities lack statistics over the whole of the credit volume, unable to pinpoint either healthy or toxic areas. Without these figures, it is impossible to get a clear picture of the financial situation and the total risk exposure. If this information had been publicly and readily available, alarm bells would have rung earlier and the Federal Reserve would have been able to avoid such painful and consequential mistakes.

Regardless of the dictates of former President Bush and his conservative compatriot Alan Greenspan, self-regulation is not the solution. A national regulatory mechanism is more than necessary for the financial players to operate successfully, seeing the credit volume has a tendency to jam at steady intervals, driven by, amongst other things, financial invention. Here again, monetary policy control is required, through the central bank, in order to prevent extreme credit surges and the subsequent crises.

A new regulation of Wall Street ought even to establish legislation and a judicial framework that gives the Federal Reserve, or another authority, the right to quickly take over the bankrupt financial institute and to wind them down in an orderly fashion. Such mechanisms don’t exist in the United States and so the handling of the American bank crisis quickly ends up in the political muck and mire.

Only when the U.S. has controls that cover the whole of the credit system will it be possible to decide the required level of capital and the level of exposure to risk which, when looked on as a whole, is desirable.

A new regulatory system in America would also inspire the international community to take control of the global finance markets, tax havens, bonus systems, credit assessment institutes et al. The fact of the matter is America is no exception. Similar deficiencies to those found in the American system can be found in regulatory bodies all over the world.

A better watch over Wall Street is a step in the right direction but new regulation of the financial markets cannot guarantee a crisis-free future.

First, regulation is undermined with time through new financial innovations and techniques. In addition, the regulator easily becomes a prisoner bound to those he or she is charged with regulating and, over time, will begin to defend his or her own interests rather than those of the economy as a whole. The historical proof of this is overwhelming. Once the crisis clouds have dispersed it will not be long until Wall Street carves out a new regulatory system.

Secondly, a central bank is needed to limit the growth of the volume of credit before a boom transforms, unchecked, into wild speculation. As it has been said, rather jauntily, it is a question of taking away the punch bowl before the party begins. The primary explanation behind the modern financial crisis is, therefore, a far too expansive monetary policy that fuelled lending and, eventually, a credit bubble. Alan Greenspan’s administration has illustrated this theory perfectly.

Today’s crisis will give the United States a new fiscal regulatory system – unless the strong self- interest of Wall Street doesn’t put a spoke in the wheel. At best, the new regulations will lessen the risk of a future crash. At worst, they’ll be the driving force behind it.